Interest Rate Parity
In foreign exchange terminology, Interest Rate Parity refers to the theoretical relationship between the spot exchange rate, the forward rate and the interest rate differential between the two currencies involved in a particular currency pair. Basically, Interest Rate Parity requires that the interest rate differential equals the difference between the forward and spot rates.
In practice, Interest Rate Parity is used to price forex forwards, futures and options in the foreign exchange market on a theoretical basis. This methodology incorporates the idea that the cost of carry until the forward date should be approximately equal among those who take either of two choices. For example, if you have Japanese Yen now but need to sell them and buy U.S. Dollars for delivery in two month’s time, you can fix your forward exchange rate using two different methods. The first technique would involve selling the Yen and buying Dollars value spot and then depositing the Dollars for two months at the prevailing interest rate for U.S. Dollars. Alternatively, you could invest the Japanese Yen for two months at the interest rate prevailing in Japan and also enter into a forward contract to sell those Yen and buy U.S. Dollars two months forward. Interest Rate Parity implies that you should have the same all-in exchange rate after two months using either option, otherwise an arbitrage opportunity might exist.